managers looking for critical data needed for successful risk analysis
and subsequent risk hedging would be well advised to consider
prediction markets. Also known as decision markets, prediction markets
have consistently proven themselves to be accurate predictors of a wide
range of future events. This article examines these markets and
discusses their considerable potential for use in risk management.
Prediction Markets Defined
markets are markets in which people bet on the outcomes of all types of
events—political, economic, catastrophic, scientific, financial,
cultural and so on. The most famous prediction market is the Iowa Electronic Market
where anyone can bet up to $500 on U.S. politics. Established in 1988,
this market has correctly predicted the outcome of every U.S.
presidential election since its inception. Moreover, it typically
predicts the percentages of votes garnered by the major candidates to
within less than one percentage point, consistently producing more
accurate results than even voter polls and expert opinion.
are many other notable predication markets as well. Some deal in real
money like the Iowa Exchange while others use artificial money that can
be traded in for prizes. At the Foresight Exchange
people can bet on the outcomes of nearly every conceivable event in
categories that include news, politics, arts and entertainment,
finance, religion, disasters, and science and technology. The NewsFutures Market
is another comprehensive prediction market that offers betting on the
likelihood of specific events occurring in the realms of politics,
economics, science, natural disasters and more.
As its name implies, the Hollywood Stock Exchange
is a prediction market that allows people to bet on the fortunes of
Hollywood film and their movie stars. This market consistently
forecasts the opening-weekend revenues of major movies more accurately
than even the movie industry’s own official forecast. At the 2003
Hollywood Oscars, this market also correctly predicted 35 of the top 40
The range of prediction markets is as varied as the public’s interests. TradeSports and the Athletic Stock Exchange specialize in sports and current events, while Long Bets is devoted to long-term predictions. There is even a market solely for German political and economic events called Wahl$treet.
private companies have put their own versions of these markets to use
in their own operations. Hewlett-Packard uses prediction markets to
generate unofficial forecasts of its sales. Impressively, its
prediction market has predicted H-P sales more accurately than the
company’s official forecasts 15 out of 16 times.
According to a July 2003 Wall Street Journal
article, Credit Suisse First Boston analyzed prediction markets in 2003
and found them to be “uncannily accurate” in predicting a broad scope
The Origin of Prediction Markets
prediction markets trace their origin to the 1600s, when scientific
research was practiced quite differently than today. At that time, a
few major universities held a virtual monopoly on research, recognizing
only each other’s theories, and refusing to recognize the theories and
research of “outsiders” who were not part of their inner circle. Many
of these outsiders argued that their theories should be judged by
empirical standards, and not by whether or not their results agreed
with the prevailing wisdom of the inner circle. In an attempt to
dismantle the teaching monopoly that a few British medical schools held
on setting medical practices, chemical physicians in the 1600s—barred
from teaching in the inner circle medical schools—offered the following
wager in 1651, as cited by Allen Debus in his 1970 book, Science and
Education in the Seventeenth Century:
ye Schooles…Let us take out of the hospitals, out of the camps, or from
elsewhere, 200 or 500 poor people, that have fevers, pleurisies, etc.
Let us divide them into halfes, let us cast lots, that one halfe of
them may fall to my share, and the other halfe to yours;…we shall see
how many funerals both of us shall have; But let the reward of the
contention or wager, be 300 Florens, deposited on both sides: Here your
business is decided.”
reasons that can only be conjectured, this concept lay dormant for more
than three centuries until the late 1900s, when prediction markets
But How Do They Work?
mechanics of these markets are essentially those of a horse race.
Instead of entering a horse, a person enters a “claim” in a prediction
market. A claim is simply a statement that something will happen by a
example, currently, one of the claims in the Iowa Electronic
Market concerns the outcome of the 2004 Democratic National
Committee, which will determine the Democratic nominee for President of
the United States. Claims can be made for John Kerry, John Edwards and
the other major Democratic candidates.
a typical prediction market, the holder of a winning claim (i.e., one
that comes true) receives a dollar, while the holder of a losing claim
(i.e., one that does not come true) receives nothing. For
example, in March 2004, the cost of a claim on John Kerry in the
Iowa Electronic Market was 89 cents. If a bettor bought this claim and
John Kerry subsequently won the 2004 Democratic presidential
nomination, then the holder would receive one dollar for the claim,
thus earning a profit of 11 cents.
a one-dollar payoff in a prediction market represents 100 percent
probability or certainty of an event coming true, and because zero
payoff represents zero probability, the cost of a claim in a prediction
market is actually the market’s consensus determination of the
probability of a claim coming true. In the example above, the 89-cent
cost of a claim on John Kerry means that the consensus of bettors in
this market is that John Kerry has a 89 percent probability of being
the 2004 Democratic candidate for president. By contrast, the cost of a
claim on John Edwards was 10 cents at the beginning of March.
Interestingly, a claim on Hillary Clinton would cost one cent even
though she was not currently in the race, making her a 100 to 1 long
shot. Of course, these probabilities change constantly as political
events continue to unfold.
as with pari-mutuel horse racing, the estimated probabilities and the
actual payoffs in a prediction market are set by the bettors. When more
money is bet on a particular claim to win (i.e., come true), it means
that bettors have attributed a higher probability to that claim so the
cost increases and the payoff is less should it come true. With long
shots, less money is bet on a claim so there is a higher payoff if that
claim should come true. Thus, prediction markets are just
like betting on horses—if a heavily favored horse wins, its payoff is
minimal, and vice versa if a long shot is the winner.
rationale underlying prediction markets is rather straightforward: they
are able to flush out information that otherwise would not be
available. Individuals around the world have different tidbits of
inside information, and they know that using such information can
enable them to earn a profit. Prediction markets are able to quickly
and successfully aggregate such information as no other mechanism
probabilities existing in a prediction market thus reflect the
collected wisdom of knowledgeable people everywhere, including those
with inside information. Not surprisingly, academic studies have found
that these markets are highly consistent (although not infallible)
predictors of future events. Impressively, these markets consistently
predict better than any other prediction tool, including expert
opinion, quantitative modeling and computer simulations.
risk managers can look to prediction markets in order to obtain the
world’s best and most informed probability estimates of all types of
events happening, including crises and disasters. The probabilities in
these markets continually reflect the collected wisdom of knowledgeable
experts and savvy insiders. Moreover, because these markets exist only
in cyberspace, the prices of claims in these markets are mostly immune
to government regulation, political pressures, monopoly pricing and
other factors that routinely affect and influence the prices in
financial and commodity markets, keeping the probabilities in these
ability of prediction markets to flush out inside information is what
spawned the U.S. Pentagon’s recent Terrorism Futures Market, which was
quickly terminated after the announcement of its existence in July of
2003 caused a sharp Congressional outcry. At first, such a market seems
ghoulish until one realizes that it actually would have the ability to
flush out inside information regarding terrorism.
Pentagon’s Terrorism Futures Market, officially known as the Policy
Analysis Market (PAM), was designed to be a prediction market operated
by the Pentagon and two private companies: the Economist Intelligence
Unit (EIU), which is a division of Economist magazine; and Net
Exchange, which was founded by several faculty members from the
California Institute of Technology. The Net Exchange was created to
conduct the actual trading of terrorism futures, with the EIU being the
only registered member.
design, bettors would enter claims through EIU, and such claims would
then trade on the Net Exchange. The Pentagon would not have had access
to the bettors’ identities or funds. However, the Pentagon would have
had access to all claims and their prices (i.e., probabilities).
were to be traded on all types of issues (politics, economics,
terrorism, etc.) in the countries of the Middle East. PAM’s Web site
gave examples of claims that included the assassination of Yasser
Arafat and a biological-weapons attack on Israel. The Pentagon’s
intention was to flush out inside information regarding events in the
Middle East, including planned acts of terrorism. Presumably, the
Pentagon intended to grow this market to include other areas of the
world, especially the United States, which is a prime terrorist target.
(In order to preempt the possibility of terrorists creating a claim and
then profiting from it by making it come true, the Pentagon intended to
limit the dollar amount of each claim so that the monetary incentive
for particular acts of terrorism was minimal.) Highly priced claims in
this market would have indicated high probabilities of the respective
events coming true (barring any preemptive action), while rising claim
prices would have suggested events that were currently being planned.
existence of this market was made public in July 2003, the response by
an angry Congress was swift and sharp. Denounced as “repugnant,”
“morally wrong,” and “unbelievably stupid,” the market was quickly
terminated by the Pentagon. Further, its creator, Admiral John
Poindexter, was forced to tender his resignation. Quite possibly, a
private concern will fill the Pentagon’s void and operate this market.
Needless to say, the ability to uncover potential acts of terrorism and
to thereafter preempt or, at least, hedge against such acts would have
enormous social utility.
catastrophes are traded in existing exchanges. Under the category of
“U.S. Catastrophes” in the Foresight Exchange, available claims include
the likelihood of suicide bombers in the United States before 2005 or a
large West Coast earthquake before 2010. Risk managers would be well
advised to periodically examine the probabilities of such claims coming
true, and thereafter implement hedging strategies should such
probabilities become, in the manager’s opinion, too high.
managers may also want to monitor other claims, as well. For example,
political outcomes can affect government penalty risks, economic
outcomes can influence profitability risks, and scientific outcomes can
affect a wide range of risks. Prediction markets routinely reflect
probabilities of stock prices, exchange rates, commodity prices,
political events, natural catastrophes, acts of terrorism, scientific
discoveries and cultural changes.
managers who operate in the world of finance will recognize that
prediction markets are actually a type of “efficient” market called a
“strong form” efficient market. In a strong-form efficient market,
prices reflect all available information, including inside information.
(By comparison, in a “semi-strong” efficient market, prices reflect
only publicly available information.) In fact, since prediction markets
are almost completely unregulated, they may be the most “efficient”
markets in all of history.
markets can be handy tools for any risk manager. With their ability to
consistently predict events, they contain critical data often needed
for successful risk hedging.
Russ Ray, Ph.D. is a professor of finance at the University of Louisville in Louisville, Kentucky.